Selling a Business May Be Getting A Lot More Expensive — or will it?

UPDATE (December 28, 2021): Contrary to earlier indications, attempts to nearly double the capital gains tax for high income earners is on hold for the time being.

As of summer 2021, all indications were that changes to the tax code are coming. These were considered necessary to fund the sharp uptick in government spending and are generally favored by Democrats, who control the White House as well as both houses of Congress, albeit tenuously in the case of the Senate.

According to an overview of the proposed changes by the American Enterprise Institute, a Washington think tank, President Biden's plan would tax capital gains and dividends as ordinary income for taxpayers who report $1 million or more. This means that capital gains for high income earners will bump up to 39.6%, the highest tax bracket under the proposal. Currently, capital gains are taxed at up to 20%, so this increase would roughly double the current rate.

So let's say you're selling your business for $10 million and are expecting $9 million at close with the remainder going into a seller note. Assuming $8 million in capital gains from the sale and no state capital gains tax, you'd take home $6.4 million under the current tax code and around $4.8 million under the proposed plan.

Here's a cleaner example assuming a $10 million valuation, all of which is capital gains and all of which would be paid at closing. Assuming the tax proposal is implemented, you would need to increase your company's valuation to over $13 million to receive as much from the transaction as you would under the current tax regime.

There was even some talk of these changes to the tax code being implemented retroactively, meaning that they would apply to the 2021 tax year, though the general consensus was that this was unlikely. However, inquiries to financial advisors had indicated that there was a good chance that there will be changes to the tax code that will take place in 2022 — even if these changes are moderated as the proposals work their way through the legislative process.

Worth thinking about if you are considering the sale of your business.

Luck versus Skill

By Lindsey Rust

What role do skill and luck play in our failures or successes? Skill, defined as the ability to apply knowledge readily in execution or performance, can be improved through diligent practice, increasing chances of a desired outcome. On the other hand, luck is unpredictable and brought by chance. As described by Michael Mauboussin in what he calls the "paradox of skill," when the outcome of an activity combines skill and luck, as skill improves, luck becomes more important in shaping results.

All outcomes in our lives can be placed on a spectrum from pure luck to pure skill. Thinking of results as the sum of a draw from a distribution of skill and a draw from a distribution of luck, statistical theorem can be used to show that:

Variance(skill) + Variance(luck) = Variance(result)

In many areas, absolute skill has been improving, but the variance of skill has been shrinking. As an example, take the sport of marathon running. Compared to 1932, marathon runners today have access to better nutrition advice, scientifically-based training plans, and coaching, which has resulted in faster average times. This improvement in skill can be seen in Olympic gold medal times, as the gold medal men's marathon time in the 2012 Olympics was 23.5 minutes faster than the gold medal time from 1932. However, the difference between the 1st and 20th place times was 39 minutes in 1932 and only 7 minutes in 2012. As the variance in skill decreases and the variance in luck remains stable, luck is playing a growing role in determining winners and losers.

The same can be seen in the world of investing. As the absolute skill level of most investors grows over time, the relative difference in their skillset becomes narrower. As investors with similar skills compete against each other, luck often triumphs.

See also:

• Michael Mauboussin talk on The Paradox of Skill and other topics

• Credit Suisse Paper, Alpha and the Paradox of Skill

Selling a Business May Be Getting A Lot More Expensive

UPDATE 2 (January 12, 2021): With Democratic control of the Senate, the incoming Biden Administration will have an easier path to implementing its tax plan. The sense is that tax reforms — including an increase in capital gains tax for high income earners — stand a reasonable chance of being passed but a far lower chance of having an impact on taxes in 2021. More here, here, and here (with a paywall on the last link).

UPDATE (November 11, 2020): With the presidential election now behind us, focus shifts to control of the Senate. The outcome of the run-off elections in Georgia will determine whether the Biden administration will be able to enact its tax plan.

The political betting markets suggest that former vice president Biden will be elected in November. Though this is far from certain, it is useful to reflect on the implications of the tax policy changes of a potential Biden administration on the sale of a small business.

According to an overview of the proposed changes by the American Enterprise Institute, a Washington think tank, his plan would tax capital gains and dividends as ordinary income for taxpayers who report $1 million or more. This means that capital gains for high income earners will bump up to 39.6%, the highest tax bracket under the proposal. Currently, capital gains are taxed at up to 20%, so this increase would roughly double the current rate.

Whether these changes are enacted also depends on which party controls the Senate, which is currently up for grabs. Should the changes be adopted, they could be effective for the 2021 tax year.

So let's say you're selling your business for $10 million and are expecting $9 million at close with the remainder going into a seller note. Assuming $8 million in capital gains from the sale and no state capital gains tax, you'd take home $6.4 million under the current tax code and around $4.8 million under the proposed plan.

Worth thinking about if you are considering the sale of your business.